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XP : Management’s Discussion and Analysis of Financial Condition and Results of Operations – Form 6-K

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Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read in conjunction with our unaudited interim condensed consolidated financial statements as of March 31, 2022 and for the three months ended March 31, 2021 and 2022 the notes thereto from our Form 6-K filed with the U.S. Securities and Exchange Commission, or the “SEC” on May 3, 2022, and “Item 5. Operating and Financial Review and Prospects” in our Annual Report on Form 20-F for the fiscal year ended December 31, 2021, filed with the SEC on April 13, 2022 and any amendments thereto, if any, or the “2021 Form 20-F.”

The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results and the timing of events may differ materially from those expressed or implied in such forward-looking statements as a result of various factors, including those set forth in “Cautionary Statement Regarding Forward-Looking Statements” and “Item 3. Key information-D. Risk Factors” of our 2021 Form 20-F.

Key Business Metrics

The following table sets forth our key business metrics as of and for the periods indicated. These supplemental business metrics are presented to assist investors to better understand our business and how it operates.

As of and for the Three Months Ended March 31,
2022 2021
Client Activity Metrics (unaudited)
Retail – AUC (in R$ billions) 873 715
Retail – active clients (in thousands) 3,504 2,993
Retail – gross total revenues (in R$ millions) 2,425 2,088
Institutional – gross total revenues (in R$ millions) 548 294
Issuer Services – gross total revenues (in R$ millions) 121 234
Digital Content – gross total revenues (in R$ millions) 11 23
Other – gross total revenues (in R$ millions) 166 145
Company Financial Metrics
Gross revenue and income (in R$ millions) 3,270 2,784
Total revenue and income (in R$ millions) 3,121 2,628
Gross Profit (in R$ millions) 2,231 1,787
Gross Margin (%)(1) 71.5 % 68.0 %
(1) Calculated as total revenue and income less operating costs and expected credit losses, divided by total revenue and income.

The following table sets forth additional business metrics as of and for the periods indicated, related to Retail AUM (as defined herein). These supplemental business metrics are presented to assist investors to better understand our business and how it operates.

As of and for the Three Months Ended March 31,
2022 2021
Retail – AUM (in R$ billions) 122.8 80.4
Mutual and Hedge Funds 59.2 35.4
Hedge Funds (Fundo de Investimento Multimercado) 27.9 12.6
Equity Funds (Fundo de Investimento em Ações) 6.3 6.3
Fixed Income Funds (Fundo de Investimento Renda Fixa) 22.7 15.1
Other Funds 2.3 1.4
Private Equity Funds 2.1 1.4
Exclusive Funds 32.5 21.8
As of and for the Three Months Ended March 31,
2022 2021
Pension Funds 15.4 8.0
Investment Clubs 2.9 2.9
Managed Portfolios 10.8 10.9
Total Retail – AUM as a % of Retail AUC (%) 14.1 % 11.2 %
Retail – AUM Weighted Average Management Fee (% p.a.) 0.4 % 0.5 %
Mutual and Hedge Funds 0.4 % 0.7 %
Hedge Funds (Fundo de Investimento Multimercado) 0.5 % 1.1 %
Equity Funds (Fundo de Investimento em Ações) 0.8 % 1.0 %
Fixed Income Funds (Fundo de Investimento Renda Fixa) 0.1 % 0.2 %
Other Funds 0.5 % 0.5 %
Exclusive funds 0.3 % 0.3 %
Pension Funds 0.6 % 0.7 %
Private Equity Funds 1.7 % 1.2 %
Investment Clubs 0.6 % 0.7 %
Managed Portfolios 0.4 % 0.4 %
Total management fees, gross of taxes (in R$ millions)(1) 329 310
From funds and portfolios managed by our asset managers 183 154
% of total management fees 56 % 50 %
From third party funds (distribution fees) 146 156
% of total management fees 44 % 50 %
(1) Consist of (i) fixed and performance-based management fees from mutual funds managed by our asset managers and sold to our retail and institutional clients; (ii) fees from distributions (rebates from fixed and performance-based management fees) of funds managed by third-party asset managers to our retail clients; and (iii) fixed management fees from XP Advisory managed portfolios and exclusive funds for high net worth retail clients.

Review of Results for the three months ended March 31, 2022

Retail – Our number of active clients rose 17% from 3.0 million as of March 31, 2021 to 3.5 million as of March 31, 2022, primarily due to (i) our growth strategy in our distribution channels, and (ii) expansion in product offerings – not only in the investment segment, but also with products such as credit cards, credit products, bank account, pension funds and insurance, and (iii) the increased number of investors in public equities within our market (characterized by a continuously increased penetration of equities as an asset class for retail investors in Brazil. However, the combined number of trades for the three months ended March 31, 2022 was 144 million, or a daily average of 2.3 million, which represented a decrease of 28% compared to the three months ended March 31, 2021, of which the total number of trades was 195 million, or a daily average of 3.3 million. Such decrease was primarily attributable to a more challenging quarter for equities, partially offset by an increase of 22% in our AUC from R$715 billion as of March 31, 2021 to R$873 billion as of March 31, 2022, driven by R$207 billion of net inflows and R$49 billion of market depreciation. Our AUM increased by 53% from R$80.4 billion for the three months ended March 31, 2021 to R$122.8 billion for the three months ended March 31, 2022, mainly due to a 21% increase of our Retail AUC, comprising (i) an increase of R$34.5 billion from mutual and exclusive funds, (ii) an increase of R$7.4 billion from pension funds and (iii) an increase of R$0.7 billion from private equity funds. Investment clubs and managed portfolios did not vary significantly in the period.

Retail Gross Total Revenues increased by 16% from R$2.1 billion for the three months ended March 31, 2021 to R$2.4 billion for the three months ended March 31, 2022, due mainly to (i) revenues that are benefitted from higher interest rates, such as fixed income and float, and (ii) the increase in revenues from – credit cards, credit, pension funds and insurance products.

The weighted average management fee of our AUM decreased 0.09 percentage points, from 0.5% for the three months ended March 31, 2021 to 0.4% for the three months ended March 31, 2022, resulting from a decrease in management fees we earn from our mutual and hedge funds of 0.3 percentage points and from our private equity funds of 0.5 percentage points.

Institutional – gross revenues increased by 86% from R$294 million for the three months ended March 31, 2021 to R$548 million for the three months ended March 31, 2022. This increase was primarily attributable to an increase in market volatility, which led to an increase in hedging operations as our institutional clients sought to hedge their market positions.

Issuer Services – gross revenues decreased by 48% from R$234 million for the three months ended March 31, 2021 to R$121 million for the three months ended March 31, 2022. This decrease was primarily attributable to a decrease in equity and debt capital markets activity in January and February 2022, which was partially offset by a slight increase in such activity in March 2022.

Digital Content – gross revenues decreased by 53% from R$23 million for the three months ended March 31, 2021 to R$11 million for the three months ended March 31, 2022, mainly attributable to lower revenues for the three months ended March 31, 2022 from Xpeed, our online financial education portal, Info Money, our investment portal, and Expert, our content platform.

As a result, our net revenue increased by 19% from R$2,628 million for the three months ended March 31, 2021 to R$3,121 million for the three months ended March 31, 2022. Gross margin also increased 3.5 percentage points from 68.0% for the three months ended March 31, 2021 to 71.5% for the three months ended March 31, 2022, driven by decreased costs of commissions as a percentage of net revenue due to increased participation of B2C – which is not commissioned – in the channel mix. Selling expenses decreased 57% from R$44 million for the three months ended March 31, 2021 to R$19 million for the three months ended March 31, 2022 and administrative expenses increased 34% from R$966 million for the three months ended March 31, 2021 to R$1,293 million for the three months ended March 31, 2022. As expenses grew less than total revenue and income, and gross margin increased, net income increased 16%, from R$734 million for the three months ended March 31, 2021 to R$854 million for the three months ended March 31, 2022, and net margin decreased 0.5 percentage points from 27.9% to 27.4% over the same period.

Results of Operations

Three Months Ended March 31, 2022, Compared to the Three Months Ended March 31, 2021

The following table sets forth our income statement data for the three months ended March 31, 2021 and 2022:

For the Three Months Ended March 31,
2022 2021 Variation (%)
(R$ millions, except for percentages)
Income Statement Data
Net revenue from services rendered 1,265 1,455 (13.0 )%
Net income from financial instruments at amortized cost and at fair value through other comprehensive income (145 ) 31 n.m.
Net income from financial instruments at fair value through profit or loss 2,001 1,143 75.1 %
Total revenue and income 3,121 2,628 18.8 %
Operating costs and expenses
Operating costs (864 ) (837 ) 3.2 %
Selling expenses (19 ) (44 ) (56.8 )%
Administrative expenses (1,293 ) (966 ) 33.8 %
Other operating income expenses, net 18 n.m.
Expected credit losses (26 ) (3 ) 766.7 %
Interest expense on debt (48 ) (10 ) 380.0 %
Share of profit or (loss) in joint venture and associates (14 ) (1 ) 1,300.0 %
Income before income tax 856 784 9.2 %
Income tax expense (2 ) (50 ) (96.0 )%
Net income for the period 854 734 16.3 %

n.m. = not meaningful.

Total revenue and income

Total revenue and income increased R$493 million, or 18.8%, from R$2,628 million for the three months ended March 31, 2021 to R$3,121 million for the three months ended March 31, 2022. Net revenues from services decreased R$190 million, or 13.0%, from R$1,455 million for the three months ended March 31, 2021 to R$1,265 million for the three months ended March 31, 2022, primarily driven by:

· a R$81 million decrease in brokerage commissions, as a result of a 28% decrease in the daily average revenue trades in retail for the three months ended March 31, 2022 compared to the same period of 2021, despite the increase in the number of active clients (which grew 17% from 3.0 million in the same period).
· a decrease of R$178 million in revenue from securities placements, primarily attributable to a decrease in executed deals and transactions, driven by (i) Equity Capital Markets, or “ECM,” following a decrease from 12 executed deals for the three months ended March 31, 2021, to 5 executed deals for the three months ended March 31, 2022, and (ii) Debt Capital Markets, or “DCM” division, following a decrease from 43 transactions for the three months ended March 31, 2021 to 23 transactions for the three months ended March 31, 2022;
· an increase of R$19 million in management fees, as a result of (i) management fees from our funds and managed portfolios, which grew 6% from R$310 million for the three months ended March 31, 2021 to R$329 million for the three months ended March 31, 2022 as a result of a 53% increase in AUM, and (ii) fees from distributions (rebates from management fees) of funds managed by third-party asset managers, which decreased 6% from R$156 million to R$146 million. Management fees attributable to funds managed by third parties (fees from distributions) decreased by 6 percentage points, from 50% for total management fees from the three months ended March 31, 2021 to 44% for the three months ended March 31, 2022, while management fees attributable to funds and portfolios managed by our asset managers increased by 6 percentage points, from 50% for the three months ended March 31, 2021 to 56% for the three months ended March 31, 2022. For the three months ended March 31, 2022, 3% of management fees were performance-based and 97% were non-performance-based (i.e., fixed annual fees);
· a decrease of R$11 million in revenue from the sale of our educational products through our XP Educação, due to the absence of in-person events and courses.
· a R$4 million increase in insurance brokerage fees, driven by increased sales of pension funds to retail clients and the overall expansion of retail AUC by 22% from R$715 billion for the three months ended March 31, 2021 to R$873 billion for the three months ended March 31, 2022;
· a R$13 million decrease in other services, resulting from a decline in other ancillary revenues related to trading operations, such as third-party trading platform fees; and
· net of a R$6 million increase in taxes and contributions on services for the three months ended March 31, 2022.

Net income from financial instruments represented a R$683 million increase in total revenue and income, driven by the growth in our retail investment distribution platform (retail clients grew by 17% for the three months ended March 31, 2022) and our institutional businesses that grew R$254 million, or 86%, for the three months ended March 31, 2022 in comparison to the same period of 2021.

Operating costs and expenses

Operating costs. Operating costs increased R$27 million, or 3.2%, from R$837 million for the three months ended March 31, 2021 to R$864 million for the three months ended March 31, 2022. This increase was primarily attributable to a R$60 million increase in other costs, despite a R$40 million decrease in commission costs payable to our IFAs. In addition, clearinghouse fees increased R$3 million and third parties’ services expenses decreased, a R$17 million. As a percentage of total revenue and income, our operating costs decreased 4.2 percentage points, from 31.8% for the three months ended March 31, 2021 to 27.7% for the three months ended March 31, 2022.

Selling expenses. Selling expenses decreased R$25 million, or 56.8%, from R$44 million for the three months ended March 31, 2021 to R$19 million for the three months ended March 31, 2022, due to higher investments made in March 31, 2021 in advertising and publicity expenses in connection with our traditional, online and social media advertising initiatives, in line with our marketing strategy to increase brand awareness, attract new customers and increase our market share.

Administrative expenses. Administrative expenses increased R$327 million, or 33.8%, from R$966 million for the three months ended March 31, 2021 to R$1,293 million for the three months ended March 31, 2022. This increase was primarily attributable to:

· a R$206 million, or 29.7%, increase in personnel expenses related to an increase in total employee headcount of 59%, reflecting our fast growth, the expansion of recently launched business lines and especially the accelerated expansion of our technology team;
· a R$49 million, or 50.1%, increase in data processing expenses, mainly related to consultancy services in connection with the operation, development and maintenance of our platform’s software; and
· a R$5 million, or 19.2%, increase in technical services, mainly due to technology solutions related to online and social media.

Other operating income (expenses), net. Other operating income, net decreased from R$18 million for the three months ended March 31, 2021 to R$42 thousand for the three months ended March 31, 2022. This decrease was primarily due to the combined effect of (i) a decrease of R$15 million related to revenue from incentives from Tesouro Direto, B3 and others for the three months ended March 31, 2022; (ii) an increase of R$3 million related to charitable contributions; (iii) R$5 million related to other operating expenses, mainly related to associations and regulatory fees, fines and penalties; and (iv) R$3 million related to legal proceedings and settlements with customers.

Income before income taxes

As a result of the foregoing, income before income taxes increased R$72 million, or 9.2%, from R$784 million for the three months ended March 31, 2021 to R$856 million for the three months ended March 31, 2022.

Income tax expense

Income tax expense decreased R$48 million, or 96.0%, from R$50 million for the three months ended March 31, 2021 to R$2 million for the three months ended March 31, 2022, mainly impacted by a result of (i) revenues at the level of entities and investment funds that adopt different taxation regimes according to the applicable rules in their respective jurisdiction and (ii) tax losses perceived by XP CCTVM specially due to increase of operating expenses and decrease of revenues from services rendered. These elements resulted in a decrease in our effective tax rate from 6.4% for the three months ended March 31, 2021 to 0.3% for the three months ended March 31, 2022.

Net income for the period

As a result of the foregoing, net income increased R$120 million, or 16.3%, from R$734 million for the three months ended March 31, 2021 to R$854 million for the three months ended March 31, 2022.

Liquidity and Capital Resources

As of March 31, 2022, we had R$4,667 million in cash and cash equivalents. We believe that our current available cash and cash equivalents and the cash flows from our operating activities will be sufficient to meet our working capital requirements and capital expenditures in the ordinary course of business for the next 12 months.

The following table shows the generation and use of cash for the periods indicated:

For the Three Months Ended March 31,
2022 2021
(R$ millions)
Cash Flow Data
Income before income tax 856 784
Adjustments to reconcile income before income tax (554 ) 233
Income tax paid (238 ) (236 )
Contingencies paid (1 ) (1 )
Interest paid (7 )
Changes in working capital assets and liabilities (1,198 ) 629
Adjusted net cash flow (used in) from operating activities excluding net cash flow (used in) from securities, repos, derivatives and banking activities (1,141 ) 1,409
Net cash flows from (used in) securities, repos, derivatives 2,244 (1,048 )
Net cash flows from (used in) operating activities 1,103 361
Net cash flows from (used in) investing activities (126 ) (162 )
Net cash flows from (used in) financing activities (25 ) (26 )

Our cash and cash equivalents include cash on hand, interbank certificate deposits with banks and other highly liquid securities purchased under agreements to resell with original maturities of nine months or less, which have an immaterial risk of change in value. For more information, see notes 6 and 7 to our audited consolidated financial statements of our 2021 Form 20-F.

Net cash flows from (used in) operating activities

Our net cash flows from operating activities increased from R$361 million in the three months ended March 31, 2021 to R$1,103 million for the three months ended March 31, 2022, primarily driven by: (i) higher balance of securities and derivatives that we hold in the ordinary course of our business as a retail investment distribution platform and as an institutional broker dealer (with respect to the sale of fixed income securities and structured notes); (ii) our strategy to allocate excess cash and cash equivalents from treasury funds, from floating balances and from private pension balances to securities and other financial assets. These balances may fluctuate substantially from quarter to quarter and were the key drivers of the net cash flows from operating activities in the three months ended March 31, 2022; and (iii) Increases in our banking activities from loans operations, market funding operations mainly derived from deposits (time deposits), structured operations certificates, or “COEs” and other financial liabilities which include financial bills as a result of our expected growth in banking services vertical.

If the variation from those lines were to be excluded from the analysis, adjusted net cash flows from operating activities would have decreased from R$1,409 million for the three months ended March 31, 2021 to cash flow used in operating activities of R$1,141 million for the three months ended March 31, 2022, mainly reflecting foreign exchange differences.

Net cash flows from (used in) investing activities

Our net cash used in investing activities decreased from R$162 million for the three months ended March 31, 2021 to R$126 million for the three months ended March 31, 2022, primarily affected by a decrease in investment in intangible assets (mostly IT infrastructure and capitalization software development) from R$114 million for the three months ended March 31, 2021 to R$5 million for the three months ended March 31, 2022, which was partially offset by increased investments in associate and joint ventures from R$23 million for the three months ended March 31, 2021 to R$112 million for the three months ended March 31, 2022.

Net cash flows from (used in) financing activities

Our net cash flows used in financing activities decreased from R$26 million for the three months ended March 31, 2021 to net cash flows from financing activities of R$25 million in the three months ended March 31, 2022, primarily due to: (i) a decrease in transactions with non-controlling shareholders from R$2 million for the three months ended March 31, 2021 to R$0.2 million for the three months ended March 31, 2022; and (ii) an increase in payments of borrowings and lease liabilities from R$24 million for the three months ended March 31, 2021 to R$25 million for the three months ended March 31, 2022.

Indebtedness

As of March 31, 2022, we had R$1,691 million in outstanding loans, R$300 million in lease liabilities and R$173 million in outstanding debentures and R$3,363 million in senior notes issued by us. As of March 31, 2022, we were in compliance with the covenants in certain loan agreements and debentures.

Capital Expenditures

As of the three months ended March 31, 2021 and 2022, we made capital expenditures of R$138 million and R$14 million, respectively. Total capital expenditures as a percentage of total net revenue and income were 5.3% and 0.4% for the three months ended March 31, 2021 and 2022, respectively. These capital expenditures mainly include expenditures related to the upgrade and development of our IT systems, software and infrastructure, and the expansion of our office spaces due to accelerated growth in employee headcount.

We expect to increase our capital expenditures to support the growth in our business and operations. We expect to meet our capital expenditure needs for the foreseeable future from our operating cash flows and our existing cash and cash equivalents. Our future capital requirements will depend on several factors, including our growth rate, the expansion of our research and development efforts, employee headcount, marketing and sales activities, the introduction of new features to our existing products and the continued market acceptance of our products.

Tabular Disclosure of Contractual Obligations

The following is a summary of our contractual obligations as of March 31, 2022:

Payments due by period as of March 31, 2022
Total Less than 1 year 1-3 years 3-5 years More than 5 years
(R$ millions)
Borrowings and bonds(1) 5,209 1,521 516 3,172
Debentures(1) 724 173 551
Lease obligations 300 92 208
Other financial liabilities(2) 743 9 703 31
Total 6,976 1,795 1,427 3,203 551
(1) Does not include fair value adjustments of: (i) debentures in the amount of R$53.4 million; and (ii) bonds in the amount of R$154.7 million.
(2) Corresponds to contractual contingent considerations associated to investments acquisitions as of March 31, 2022. As of March 31, 2022 the maturity of the total contingent consideration payment is up to 4 years and the contractual maximum amount payable is R$879 million (the minimum amount is zero).

Off-Balance Sheet Arrangements

We did not have any off-balance sheet arrangements as of March 31, 2022.

Quantitative and Qualitative Disclosure About Market Risk

We are exposed to market risks in the ordinary course of our business, including the effects of interest rate changes and foreign currency fluctuations. Information relating to quantitative and qualitative disclosures about these market risks is described below and in note 35 to our audited consolidated financial statements included in our 2021 Form 20-F.

We conducted a sensitivity analysis for market risks we considered relevant as of March 31, 2022. For this analysis, we adopted the following three scenarios:

· Scenario I, which contemplates an increase in fixed interest rate yields, exchange coupon rates and inflation of one basis point, and an increase in the prices of shares and currencies of one percentage point;
· Scenario II, which contemplates 25% increases and decreases in fixed interest rate yields, exchange coupon rates and inflation, assuming the largest possible losses per scenario; and
· Scenario III, which contemplates 50% increases and decreases in pre-fixed interest rate yields, exchange coupon rates, inflation and interest rates, assuming the largest possible losses per scenario.

The below table sets forth the impact of each scenario on each market risk. It does not account for the risk protocols of our risk and treasury areas, which trigger risk mitigation measures as soon as losses are detected, minimizing the risk of significant losses:

As of March 31, 2022
Trading Portfolio Exposures Scenarios
Risk Factors: Risk of Variation in: I II III
(R$ millions)
Pre-fixed Pre-fixed interest rate in reais 16 82
Exchange coupons Foreign currencies coupon rate (1 ) (5 ) (11 )
Foreign currencies Exchange rates (1 ) (134 ) (249 )
Price indexes Inflation coupon rates (18 ) (36 )
Shares Shares prices (3 ) 12 (8 )
Seed money(1) Seed money (9 ) (237 ) (473 )
(15 ) (366 ) (694 )
(1) Related to seed money strategy, which includes several risk factors that are disclosed in aggregate.
As of December 31, 2021
Trading Portfolio Exposures Scenarios
Risk Factors: Risk of Variation in: I II III
(R$ millions)
Pre-fixed Pre-fixed interest rate in reais (111 ) (205 )
Exchange coupons Foreign currencies coupon rate (6 ) (11 )
Foreign currencies Exchange rates 177 384
Price indexes Inflation coupon rates (53 ) (104 )
Shares Shares prices (1 ) (132 ) 92
Seed Money(1) Seed Money (6 ) (155 ) (310 )
(9 ) (279 ) (153 )
(1) Related to seed money strategy, which includes several risk factors that are disclosed in aggregate.

Currency Risk

We are subject to foreign currency risk as we hold interests in XP Holding International LLC, one of our international financial holding companies in the United States, XP Advisors Inc., our finance services consulting company in the United States, and XP Holding UK Ltd, one of our international financial holding companies in the United Kingdom, whose equity as of March 31, 2022 was US$54.91 million (US$48.52 million as of March 31, 2021), US$3.41 million (US$1.10 million as of March 31, 2021) and GBP3.44 million (GBP1.79 million as of March 31, 2021) respectively.

The foreign currency exposure risk of XP Holding International and XP Advisors Inc. is hedged with the objective of minimizing the volatility of our functional currency (the real) against the U.S. dollar arising from foreign investments offshore. The foreign currency exposure risk of XP Holding UK Ltd has not been hedged.

On June 24, 2021, we issued senior notes due 2026 in an aggregate principal amount of US$750.0 million. The 3.250% notes due 2026 bear interest at the annual rate of 3.250%, payable semiannually in arrears on January 1 and July 1 of each year, which commenced on January 1, 2022. The 3.250% notes due 2026 are guaranteed by XP Investimentos S.A. and have been listed on the Singapore Exchange Securities Trading Limited since July 1, 2021. See “Item 5. Operating and Financial Review and Prospects-B. Liquidity and Capital Resources-Indebtedness-3.250% Senior Notes due 2026” in our 2021 Form 20-F.

On May 28, 2021, we entered into a credit agreement with Banco Nacional de México S.A. for a term loan in the amount of US$295 million. This loan bears interest at the annual rate of 0.81%, payable annually in arrears on May 23, 2022, and matures on the same date. The loan is guaranteed by collateral securities. See “Item 5. Operating and Financial Review and Prospects-B. Liquidity and Capital Resources-Indebtedness-Borrowings” in our 2021 Form 20-F.

As of March 31, 2022, we had no indebtedness denominated in U.S. dollars other than our 3.250% notes due 2026 and the credit agreement with Banco Nacional de México.

Interest Rate Risk

Interest rate risk arises from the possibility that we incur in gains or losses arising from fluctuations in interest rates on our financial assets and liabilities. The following are the risk rates that we are exposed to: (i) SELIC rate; (ii) IGP-M, the Brazilian general market price index (Índice Geral de Preços do Mercado); (iii) IPCA, the Brazilian national consumer price index (Índice Nacional de Preços ao Consumidor Amplo); (iv) PRE, the Brazilian required reference equity index (Patrimônio de Referência Exigido); and (v) foreign exchange coupon.

We have floating interest rate indebtedness, so we are exposed to interest rate risk as a result of changes in the level of interest rates, and any increase in interest rates could negatively affect our results of operations and would increase the costs associated with financing our operations. As of December 31, 2021, and 2020, substantially all of our total indebtedness consisted of floating rate debt and was principally indexed to the CDI. Furthermore, our exposure to interest rate risk also applies to our cash and cash equivalents deposited in interest-bearing accounts which are indexed to the CDI, which can affect our results of operations and cash flows.

Price Risk

Price risk is the risk arising from price changes in investment fund portfolios and shares listed on the stock exchange held in our portfolio, which may affect profit or loss. Price risk is mitigated by our management through the diversification of our portfolio and/or through the use of derivatives contracts, such as options or futures. We believe we adopt conservative price risk limits in our risk budget.

Liquidity Risk

Liquidity risk relates to maintaining sufficient cash and securities through an adequate amount of committed credit facilities to meet obligations when due and to close out market positions. We have a liquidity risk management policy, which aims to ensure a minimum level of liquidity considered adequate by our management.

This policy establishes actions to be taken in the event of liquidity contingencies, which are designed to reframe cash within required minimum liquidity limits. Our risk department is responsible for the structure and management of risks and is under the supervision of the board of directors, for the avoidance of any conflicts of interest with departments requiring liquidity.

Liquidity risk control is based on forecasts of cash and assets with credit risk. The cash forecast relies on the free funds deposited by customers, while fund allocations can be classified according to their settlement or zero settlement periods. The stressed scenario models for delays in private credit assets and the extent to which possible stress would affect our liquidity conditions.

Credit Risk

Credit risk is the risk of suffering financial losses related to non-compliance by any of our clients and market counterparties with financial obligations, agreement devaluations as a result of the deterioration in the risk rating of borrowers, reduced gains or remuneration, and concessions granted in the renegotiation of financial arrangements and recovery costs, among others.

Credit risk includes, among other risks: (i) non-compliance by counterparties with obligations related to the settlement of transactions in financial assets, including derivative financial instruments; (ii) losses related to non-compliance with financial obligations by borrowers located abroad, as a result of the actions taken by the government of the country in which they reside; (iii) cash disbursements to honor warranties, co-obligations, credit commitments or other transactions of a similar nature; and (iv) losses associated with non-compliance by intermediaries or borrowers with financial obligations pursuant to financing agreements.

In our credit operations, we use client investments as collateral to reduce potential losses and mitigate credit risk exposure by managing collateral so that they are always sufficient, legally enforceable (effective) and viable. We also monitor the value of the collateral. The credit risk management provides recommendations to set risk appetite strategies, to set limits, including exposure analysis and trends as well as the effectiveness of the credit policy. We believe our credit operations have high credit quality and we often use risk mitigation measures, primarily through client investments as collateral.

Our risk department is responsible for managing credit risk, ensuring compliance with our credit risk policy and established operating limits. Our credit policy is based on our internal scenario, including portfolio composition by security, issuer, rating, economic activity and duration of the portfolio, and on the external economic scenario, including interest rates and inflation, among others. The credit analysis department is also actively involved in this process and is responsible for assessing the credit risk of issues and issuers with which we maintain or intend to maintain credit relations. It also recommends limiting the credit risk positions of customers.

We use the National Scale Notes from the International Emission Risk Agencies to subdivide portfolios into High, Medium and Low Risk, based on an internal rating scale. Management undertakes credit quality analysis of assets that are not past due or reduced to recoverable value. For credit operations, we use the relevant client’s investments under custody with us as collateral to reduce potential losses and protect against credit risk exposure, and we manage and monitor this collateral to ensure it remains sufficient, legally enforceable (effective) and viable. Our credit risk management operations allow us to formulate risk appetite strategies and establish limits, including exposure analysis and trends as well as the effectiveness of our credit policy. As of March 31, 2022, and 2021, such assets were substantially represented by credit operations and securities purchased under agreements to resell the counterparties, which include Brazilian banks with low credit risk, securities issued by the Brazilian government, as well as derivative financial instruments transactions, which are mostly traded on the B3 S.A. – Brasil, Bolsa, Balcão.

Market Risk

Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk comprises three main types of risk: foreign exchange variation, interest rates and share prices. The aim of market risk management is to control exposure to market risks, within acceptable parameters, while optimizing returns. Market risk management for operations is carried out through policies, control procedures and prior identification of risks in new products and activities, with the purpose of maintaining market

risk exposure at levels considered acceptable by us and to meet the business strategy and limits defined by the risk committee of XP Brazil.

The main tool used to measure and control our exposure risk to the market, mainly in relation to the trading assets portfolio, is the Maps Luna program, which calculates the capital allocation based on the exposure risk factors in the regulations issued by the Central Bank for financial institutions, which we apply to verify the risk exposure of our assets. In order to comply with the provisions of the Central Bank, our financial institutions monitor our exposure and calculate it on a daily basis, in accordance with CMN Resolution No. 4,557, and submit it daily to the Central Bank. With the formalized rules, the risk department of XP Brazil has the objective of controlling, monitoring and ensuring compliance with the pre-established limits, and may decline, in whole or in part, to receive and/or execute the requested transactions, upon immediate communication to customers, in addition to intervening in cases of non-compliance and reporting all unusual events to the committee.

In addition to aforementioned controls, we adopt guidelines to control the risk of the assets that mark treasury operations so that the portfolios of the participating companies are composed of assets that have low volatility and, consequently, less exposure to risk. In the event of non-compliance with the operational limits, the treasury manager can take the necessary measures to remedy this as quickly as possible.

Operating Risk

Operating risk is the risk of direct or indirect losses resulting from a variety of internal factors associated with our processes, personnel, technology and infrastructure, and with external factors, except for credit, market and liquidity risks, such as those deriving from legal and regulatory requirements and from generally accepted standards of business behavior. Operating risks arise from all of our operations. Our objective is to manage operating risk to avoid financial losses and damage to our reputation, and also to seek cost efficiency, avoiding control procedures that restrict initiatives and creativity.

The main responsibility for development and implementation of controls to deal with operating risks is attributed to key management within each business unit, and is supported by the development of our general standards for management of operating risks in the following areas: (i) requirements of segregation of functions, including independent authorization for transactions; (ii) requirements of reconciliation and monitoring of transactions; (iii) compliance with legal and regulatory requirements; (iv) documentation of controls and procedures; (v) requirements of periodic assessment of the operating risks faced and the adequacy of the controls and procedures for dealing with the identified risks; (vi) development of contingency plans; (vii) professional training and development; and (viii) ethical and business standards.

Our financial institutions, in compliance with the provisions of CMN Resolution No. 4,557, have a process that encompasses institutional policies, procedures, systems and contingency plans and business continuity for the occurrence of external events, in addition to formalizing the single structure required by the Central Bank.

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